Looking at the SP 500’s Valuation

A better title for tonight’s post might be “What is the True Growth Rate of Q1 ’15 SP 500 Earnings ?” since so many look the SP 500’s p.e ratio and draw conclusions from that metric.

I asked Greg Harrison, the Thomson Reuters earnings data guru, what the Q1 ’15 SP 500 earnings growth rate is, ex-Energy, and ex-Apple. Here is what Greg sent Trinity in response to the question:

Overall: 2.1%

Ex-AAPL: 0.6%

Ex-Energy: 10.2%

Ex-AAPL & Energy: 8.8%

* Source: Thomson Reuters, 5/13/15

If you review the last Weekly Earnings Update, from this weekend, you can see how the overall growth rate distorts the PEG (the P.E-to-Growth rate) ratio, but looking at the SP 500, either on an ex-Apple or Ex-Energy growth rate, the 17.5(x) p.e ratio on the SP 500 doesn’t look too salty, since ex-Energy the SP 500 is trading at 1.7(x) its current growth rate, and “ex” both Energy and AAPL, on a PEG basis, the SP 500 looks fairly valued at 2(x) PEG. (Trinity is long AAPL and some Energy exposure for clients.)

Frankly, when Greg sent me the data on Wednesday, May 13th, I was surprised that “ex-Energy” the Q1 ’15 SP 500 earnings growth rate was +10.2%.

At 3/31/15, the SP 500 was trading at about 10(x) cash-flow per JP Morgan’s Guide to the Market.

The one valuation tool that has always intrigued me was the “capitalized earnings” model, which Brian Wesbury, the First Trust economist has written about through the years.

Using the current “forward 4-quarter estimate” of $122.17 found on the Weekly Earnings Update, and dividing it by the current 10-year Treasury yield of 2.25%, “fair value” for the SP 500 is  roughly 5,400, with the SP 500 currently 60% undervalued. Undoubtedly some find that preposterous, so let’s use the current yield on the iShares, iBoxx Investment Grade Bond ETF of 3.35%, would still leave the SP 500 40% undervalued. ( I chose the LQD versus the AGG given the higher current yield.)

The point is if we “solve” for the investment grade bond yield that would find for today’s 2,100 close on the SP 500 would be 5.82%.

Investment grade credit spreads could rise by 247 bp’s (theoretically), with no change in the forward earnings estimate, and it would only mean that the SP 500 find today’s “theoretical fair value”.

Conclusion / summary:  My own conclusion is that when the 35 year bull market in Treasuries ends, it will be very painful. I can only wonder how many are chasing yield in the short end of the yield and credit curves, trying to make nickles. For reasons cited here and here, I have clients positioned – in the event of a bond market rout – that stocks will decline in value, it is just that the decline should be short-lived and not as bad as the ultimate decline in Treasury and investment grade bond prices.

We are seeing a decent increase in rates not only in the US but in Germany and across Europe, the last 5 weeks.  is this another head fake or will there be a genuine bear market in bond prices this time ?

We’ll know shortly.




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